Citigroup just published and distributed its Global Equity Quarterly report to clients. Robert Buckland, Citi's Chief Global Equity Strategist, recommends being underweight U.S. equities since he sees better opportunities elsewhere.

"The individual investor is still pouring money into bond funds and they're not doing so into equity funds. The only place they'll kind of tip their toe into is emerging markets, but domestic or U.S. oriented equity mutual funds continue to see outflows, other than income-oriented or dividend stuff.

Number two, if you look at valuation criteria where you kind of normalize earnings on a PE basis using 10 year rolling average kind of the way Schiller does but not exactly and then look at the five year forward of the 10 year yield in other words look to futures contracts to normalize away from financial repression, markets still look pretty attractive on the equity side. So there is a very clear difference in my mind between fixed income and equities I for the life of me don't understand why people are buying U.S. treasuries."

Levkovich's weekly Monday Morning Musings note, however, builds on his cautious tone on earnings. He argues margin pressures are building up. He also thinks the fiscal-cliff at the end of the year and the presidential elections may cause companies to stay some investments during the summer until there is more clarity on the direction of U.S. policy.

Moreover, if GDP slides back to 1.2 percent in the second quarter, as Citi projects, then that would raise some doubt about domestic economic strength and could hurt equities.

In recent years, the VIX – aka the volatility index, aka the fear index – has become a popular tool among investors who are looking to gauge market sentiment, and ultimately use it to predict the direction of the markets.

However, Tobias Levkovich – Citi's top U.S. equity strategist – did some research and found that the VIX might have very little predictive value. Furthermore, he argues that even if it had predictive powers, it would offer no advantage since VIX data is so widely available.

For example, the VIX has not been a great predictive indicator for future stock price direction unless it is stressed considerably. Indeed, a study we conducted looking at the VIX climbing 25% from lows generates only random stock price outcomes (see Figure 1). When reviewing +25% moves off of the low point in the VIX within any month and seeing what happens to equities over the next three, six and 12 months only confirms that it is a rather inadequate predictor of future trend even as so many pundits use it to get a “fix” on investment community leanings. Moreover, easily available data provides little if any unique insight for fund managers seeking an “edge.”

The model is a contrarian indicator, which means high levels of panic mean it's time to buy stocks.

In his latest Monday Morning Musings report, Levkovich notes "sentiment has shifted rapidly from complacency in March to panic in the latest readings on our unique Panic/Euphoria Model." More from his note:

“Panic” resurfaces. Admittedly, markets rarely get that "cataclysmic crescendo of capitulation" to call for buying stocks, but proprietary measures such as the Panic/Euphoria Model now are intimating that upside opportunity has re-emerged. Meetings with institutional investors do not anecdotally demonstrate that people are “freaked out,” but the sharp decline over the past six weeks has caused significant deterioration of sentiment (even amongst credit investors). Other metrics still are not providing the requisite buy inflection such that a more positive view for stocks is appropriate but that nuance does not imply a willingness to grow long bull horns yet.

Citigroup's chief U.S. equity strategist Tobias Levkovich on the (cautious) case for buying stocks at current valuations:

...Yet, as we have shown in the past, the longer-term argument for equities versus the alleged stored value of gold seems quite forceful at its current deviation (see Figure 1). Indeed, the chart shows just how out of favor equities are. But that was also the case in the early 1980s and we prefer to learn from history rather than repeat it.

Citigroup's proprietary Panic-Euphoria model is closely watched, especially after it successfully predicted a 98 percent chance of a double-digit return in stocks last October.

Tobias Levkovich, Citi's top U.S. equity strategist was on Bloomberg TV saying the hard-selling is almost over. He also said the model went into panic last Friday, and is still in panic which is a positive sign for markets:

"We think it is a correction. We're not convinced that we're done with the correction, but we think most of the hard selling is over.

Last Friday our panic-euphoria model, one of our proprietary sentiment models went into panic, that gives us a very high probability, almost 90 percent probability that markets are up in 6 months, and 96 percent probability that they're are up in 12 months.

We're still in panic today and as a result it would indicate that yes, if you have a six to 12 month time horizon buy the market. If you're looking at the next six to 12 days, that's not a great indicator, look at other catalysts for change for that."

Barron's Michael Santoli offered his rebuttal on Saturday saying that the FT's observations where late and the ultimate conclusions tend to be faulty.

But the most thoughtful and comprehensive examination of this call was a meaty 28-page report titled Equity Cult Still Dying published on May 9 by Robert Buckland, Citi's brilliant Chief Global Equity Strategist.

In this report, we revisit the cult of the equity. We find that it continues to look sickly, if not dead, across the world. Emerging Markets remain a notable exception. This is not necessarily bearish for global share prices, but does suggest that a meaningful rerating is not imminent. Perhaps the greatest hope for a recovery in the equity cult is an intense bear market in bonds. But perhaps we should be careful what we wish for.

The Rise Of The Equity Cult

In the late 1950's, all of the conditions were just right to spark a massive global shift into stocks from bonds. The FT and Goldman Sachs Peter Oppenheimer would tell you it happened in 1956 when Ross Goobey, the manager of UK's Imperial Tobacco pension fund, rocked the world when he said stocks provided better long-term inflation adjusted returns than bonds.

Buckland writes that it was actually the groundbreaking work of Nobel prize winning economist Harry Markowitz, the father of modern portfolio theory.

The rise of the equity cult coincided with the rise of modern portfolio theory. Harry Markowitz provided equity cultists with their most powerful preaching aid; that a diversified portfolio of individually risky equities could be constructed to maximise return and minimise risk.

The combination of Markowitz's theory, the Ross Goobey moment, and the extraordinary real returns in the stock market (the 1950s was the best decade for real returns in the 20th century), ignited the beginning of the cult of equity.

As you can see in the chart above to the right, pension funds aggressively shifted their assets into stocks in the 1950s.

And stock and bond valuations, based on yield, switched places in 1958. This trend lasted for 50 years!

The Fall Of The Equity Cult

As you can see in the charts above, pension funds have been shifting out of stocks and valuations crossed again.

Buckland goes through all the reasons why the equity cult has come under attack:

...Most importantly, the returns from equities have collapsed. US real annual equity returns in the 2000s were a miserable -3.5% while bonds returned +4.0%. Performance chasers have been switching back to bonds accordingly.

...Pension funds saw equities as a less clean fit with their maturing liability profiles. Index-linked bonds offered a better inflation hedge. The rise of defined contribution pension funds, where individuals take on more of the return risk, has generally encouraged more cautious investment strategies, which tend to minimise equity exposure. Even modern portfolio theory has been questioned by the recent financial crisis. Rising correlations across equity markets have diluted the apparent benefits of diversification.

The shrewd Buckland recognized that writing this report would bring out the contrarians who would cite the last time there was a call for the "death of equities."

After all, Business Week famously put “The Death Of Equities” on its front cover back in 1979 just as the S&P set off on a 20-year bull run. If, instead of buying that copy of the magazine in 1979, an investor had put the $1.25 magazine cover price into the S&P instead, then it would have been worth $33 in 1999. That’s a serious opportunity cost.

Having said that, Buckland believes that the unfavorable underlying secular fundamentals of the market may trump all of that contrarian-ness.

The building blocks of the last equity cult remain elusive. Equities have not put in a decade of strong performance relative to bonds. The legacy of the financial crisis means that equity-friendly economic growth is less evident. Baby boomers are retiring. The TIPs market offers a more obvious inflation hedge. Modern portfolio theory is not such a compelling marketing tool. Equities are not especially cheap (on a straight dividend yield basis; they look better if we include buybacks).

Here's a summary that Buckland supplied

Hope For Stocks?

Buckland believes that the "best hope" for a comeback in the equity cult is the fact that bonds look expensive. "The current combination of investor risk aversion and QE-influenced financial repression leaves bonds looking pricey," he wrote.

There's also the matter of Tobias Levkovich, Citi's top U.S. equity strategist, and his"Raging Bull" thesis saying that improving housing prospects, increasing energy self-sufficiency, favorable demographics, and the US manufacturing renaissance will be bullish for U.S. stocks at least in the medium-term.

Buckland acknowledges Levkovich's thesis but argues that "a return of the equity cult is not needed" to fuel the "Raging Bull" rally. The equity cult represents a much deeper and much longer-term trend.

For now, Buckland ultimately believes that the U.S. equity cult is not yet dead. Just sick.

Citi's Tobias Levkovich is out with his latest update to the firm's proprietary Panic/Euphoria model.

In a nutshell, panic is high, and that's extremely bullish of stocks. From Levkovich's note to clients:

The Panic/Euphoria Model is in panic territory currently versus edging into euphoria back in 2007 and 2008, implying that investors are positioned far more defensively at present. While the euphoria readings several years ago signaled an 84% probability of a falling S&P 500 in the following 12 months, there is now a better than 96% chance of making money in the next year.

Citi's Tobias Levkovich argues that America's aging population is actually heading toward the age where they will start saving more aggressively. Confidence in stocks is further bolstered by the fact that stocks have been rallying in the last few years.

Conventional wisdom would suggest that when people get older, they're more likely to sell off their stocks and head to fixed income securities like bonds.

But having considered the amount of wealth that's been destroyed in the markets in recent years, Levkovich thinks that there are plenty of reasons why investors would be flockin to stocks, despite shinking time horizons.

Here's what he wrote in a note published earlier this week:

More impressively, the next few years should see new investors come of savings age. As we have noted previously, the 35- to 39-year-old cohort should begin to grow again starting in 2013 and this group is very crucial to retirement savings and equity market trend (see Figure 10). While some have suggested that this baby boom echo won’t buy stocks in view of the 2000–09 market trend, we would suggest that they look back at the 1980s and 1990s, which followed a 16-year bear market in stocks — the 1970s stock market problems did not deter the baby boomers and the 2000s most probably will not prevent the echo generation from buying if opportunity exists. Keep in mind that the past three years actually have been very equity friendly and behavioral psychology argues that people are most affected by their most recent experiences. Additionally, baby boomers do not have the luxury of moving their stock holdings into very low yielding fixed income instruments and have much left for their own retirements.

Levkovich thinks investors need to consider that the living large index will appreciate later this year:

"When the S&P 500 is climbing, higher end consumers get wealthier and are perceived as willing to spend; thus share prices of companies that focus on that consumer segment do well. If stock indices are falling, Living Large relative underperformance ensues. With markets likely to move sideways (with a downward bias) at least until companies report quarterly numbers next month and provide lowered 2H12 guidance, there may not be much of a relative trade to put into place, but we foresee stronger Living Large appreciation later this year."

This chart shows the performance of the Living Large index against the broader market:

Tobias Levkovich, Citi's top U.S. equity strategist says there are many indicators, both short and intermediate, that show that markets are "poised to rally this summer into the fall" despite concerns over Europe, slowing global growth, U.S. elections, and the fiscal cliff.

Citigroup's proprietary Panic-Euphoria model which successfully predicted a 98 percent chance of a double-digit return in stocks last October, is in panic mode again which signals a strong probability of gains over the next six and 12 months.

More specifically, this time around the sentiment indicator is predicting a 97 percent chance of gains by the end of the year, up from 96 percent in May.

But that isn't the only sign.

Interestingly, the intra-stock correlation between large caps has also increased showing that investors have decided that macro events move all stocks rather than consider their balance sheets, earning growth etc. "When this development was seen in the past, it was a sign of capitulation and stock indices began to change direction," according to Levkovich.

Finally, the Global Citi Economic Surprise Index which is highly correlated to the S&P 500 has fallen to "trough-like numbers" and a turnaround seems very likely. Levkovich recommends "stepping into recent weakness and buying stocks as a positive inflection in the global CESI seems imminent."

The one big risk besides Europe, China and the U.S. fiscal cliff is that earnings estimates for the second half of the year have been too high.

Citi's Tobias Levkovich is out with a note that, in contrast with some other strategists, is very bullish on the prospects for a rally over the next few months.

Though concerned by weakening global growth and the Euro crisis, he feels that a lot of that risk is priced in, and that a preponderance of other data suggests a positive inflection for markets.

Here's why he predicts a rally:

"The Panic/Euphoria Model, normalized earnings yield gap analysis and implied long-term EPS growth approaches all suggest a better than 94% chance of market gains in the next year..."

Current credit conditions and hiring intentions belie predictions of an imminent US recession.

Citi's Global Economic Surprise index is lower than its been since the crisis. It looks like a trough, and a turnaround seems likely.

Investors have fled stocks regardless of sector and quality, there's a high level of intra-stock correlation in large cap prices. This has been a good entry signal over the past few years.

Declines in earnings projections indicate an awareness of risks, investors have accounted for negative news.

Levkovich seems very confident in his prediction, and thinks the rally will run through the summer into the fall. In his words "...the horns are growing back for this resurrected bovine.." We'll see if the markets support him.

Tobias Levkovich, who heads Citi's U.S. equity strategy research, points out in a note to clients that only 30 percent of recent Wall Street analysts' earnings estimate revisions have been positive.

The two times this number was lower in the last 13 years, the U.S. economy was in recession. Note that the ratio has taken a cliff-dive recently while the S&P 500 remains elevated:

However, Levkovich doesn't believe this is a signal of an impending recession, but an opportunity to buy stocks. He writes in his note:

We continue to see data such as the Citi’s Major Economies (G10) Economic Surprise Index getting to prior lows (excluding the credit crisis period of 2008), implying that investors fears are being put into future growth expectations and some positive surprises could drive stock prices higher (see Figure 12). In the interim, sentiment, valuation and intra-stock price correlation are sending buy signals and investors should be taking advantage of recent equity market weakness.

Gross argued that given the current state of affairs in the world economy and global financial markets, "those liability structures such as pension funds and insurance companies that have depended on a 6.5 percent constant real return from stocks such as we've had over the past century are bound to be disappointed."

"It is very popular to suggest that the US stock market has been a poor investment over the past decade-plus given that the S&P 500 and the Dow Jones Industrial Average are still trading below their prior highs," Levkovich writes, "yet, a fair amount of that narrative can miss some important perspectives."

The main points underpinning Levkovich's argument:

The starting point for the measurement matters: Levokvich says that if investors got in the market after the tech bubble burst in 2002, they would have made a 70 percent return on the S&P 500 or 105 percent if dividends are factored in.

Small caps have done incredibly well against the broader market: The Russell 2000 is up around 70 percent since 2000. Levkovich writes that "it is crucial to note that mega caps have been the big underperformers weighing down the broad indices and that may be in the process of changing given our lead indicator model and likely corporate profit margin compression which generally favor larger companies over smaller ones."

Everyone is ignoring dividends: Capital gains was all the rage in the 1980s and 1990s, which makes dividends a very forgettable component of the investment story, according to Levkovich. He points out that "currently, aging baby boomers are somewhat desperate for income causing dividends to be back in vogue, but it has been 55 years since dividend yields last exceeded 10-year Treasury yields."

However, Levkovich also warned regarding stocks that "at some point, both severely high and extraordinarily low bond yields can send erroneous signals to markets as they have moved meaningfully away from the typical trend," and with the global investment climate currently characterized by heightened risk aversion, he expects stocks paying good dividends to continue to outperform.

The latest note from Citi's Tobias Levkovich takes a close look at the Fiscal Cliff – the expiration of a slew of government tax cuts and spending programs.

Should the U.S. go off the cliff, it could have an enormous impact, being twice as large as any fiscal drag since World War 2.

Interestingly, other than some millitary contractors, corporations have not reacted by changing their future plans.

From Levkovich's note:

"...corporate leaders have not downshifted on capital investment programs thus far, further arguing that management teams also expect some cooperation as we suspect lobbying for just that is occurring behind the scenes. At the same time, CEOs understand that election politics prevent a near-term resolution..."

The view seems to be that any talk that we might actually go off the fiscal cliff is just posturing by two parties in a high stakes election. With the election resolved one way or another, that impediment to resolving the cliff will be eliminated.

That's the implied position of corporations at the moment, and they're voting for it with their wallets.

Lately, stocks have exhibited extraordinarily low volume as they have grinded higher.

Meanwhile, the volatility index (VIX) has fallen to five-year lows, which has left analysts wondering if complacency has set in.

Perhaps all of this means September will be more interesting.

Citi's Tobias Levkovich writes that historically September is an underperformer. And there are some reasons why. From his latest note to clients:

September historically has not been kind to the stock market. A review of monthly index performance shows that despite two market crashes in October, the worst typical month for stocks has been September when looking back 60+ years. The explanation may be that the third quarter is less predictable than other quarters due to summer vacation-related corporate sector downtime in the US and Europe (during July and August, respectively) leaving it more dependent on the only full month of business activity which makes accurate forecasting inherently more difficult.

Nonetheless, Levkovich continues to believe things look good for stocks through the balance of the year.

When assessing all of the inputs, there is reason to believe that the major US market index could overshoot the 1,425 objective, potentially running up to 1,500, but that may require a more pro-business result on the morning of November 7th which is far from certain. As such, some pause is probable in the near term but this should not be perceived as a reining in of bullish horns; rather it should be viewed as a short period of consolidation. In the interim, the dividend theme continues to be appropriate.

The Panic/Euphoria model might be the most popular metric produced by Citi's equity strategy team. It's a contrarian indicator that sends a buy signal when it points to panic. And its track record is solid.

Unfortunately for contrarians, investors have stopped panicking. Citi's Tobias Levkovich wrote about it in a note to clients:

The Panic/Euphoria Model has moved back into complacency. The closely watched sentiment gauge is beginning to warn of an investment community that appears to have become complacent again, as was the case in late March/early April 2012 and in April/May 2011 right in front of equity market wobbles. With September historically being a challenging month for stocks, such signals should be carefully monitored.

The good news is that investors are not euphoric, which would be a screaming sell signal.

Sentiment is still far from euphoric and thus one should not expect a new bear market. Euphoria levels generate an +80% probability of down equity markets in the subsequent year (based on the backtest), which is extraordinarily high given that there is a 70% random chance of markets appreciating in the subsequent year, after buying the index on any given day. Thus, the current level of complacency alone is not overly disconcerting.

Citi's Tobias Levkovich just unveiled his 2013 target for the S&P 500 and it's bullish.

He see the index hitting 1,615, which is a more than 12 percent gain of current levels.

Of course, Levkovich recognizes that the target "may seem overly optimistic" given all of the uncertainties that remain.

But he also sees plenty of reasons for stocks to go up.

Here are some of the key points:

Valuations are attractive:

"The proprietary Panic/Euphoria Model is no longer generating a highly probabilistic sentiment based “buy” signal, but various valuation metrics and earnings-based methodologies provide a positive backdrop for further index gains.

Fed projections are bullish:

"The Fed’s lending standards survey does not intimate that the domestic outlook is facing problems given the typical nine-month lead on business activity or 12- month lead on S&P 500 revenues.

Credit is cheap:

"Economic and earnings expansion is likely even as margin concerns persist. With a helpful credit basis, one should expect improvement in capital investment, industrial production and employment to sustain US GDP development which then underscores a modest EPS growth rate to $108 in 2013 (up from $103 in 2012), which puts Citi within the broad consensus top-down estimate range of $105-$110, albeit lower than bottom-up expectations of 10%+ growth.

Washington will work on the deficit:

"Double-digit market appreciation will then require a lowering of risk premiums which is likely to be a result of policy initiative to address fiscal imbalances, almost irrespective of who wins the White House later this year.

General American awesomeness:

"A plausible shift towards The Raging Bull thesis outlined last December remains intact. The Raging Bull argument highlighted growth drivers such as the energy sector’s expansion, US manufacturing competitiveness, the explosive penetration of IT mobility and a housing rebound, combined with some positive demographic shifts for baby boom echo savers and more fiscally responsible behavior out of politicians."

And finally, people are way too worried about worst-case scenarios:

"Risks abound but risk premiums reflect many uncertainties, barring new shocks. A chaotic unraveling of European sovereign debt woes, a Chinese hard landing, new Middle Eastern tension that disrupts oil supplies and American fiscal deadlock could all be seen as new shocks that would undermine this 2013 view.

"Yet, one does not build a framework on low probability based outcomes but rather a base case with clearly identifiable risk parameters. There is no shortage of worries, but equity risk premiums near 30-year highs seem to reflect a good deal of them.

However, Citi's Tobias Levkovich thinks it's a mistake to think this way.

"Investors misperceive the Shanghai market as always having been a key lead indicator for US stocks," writes Levkovich.

Here's more:

Correlation was high around the US credit crisis but appears to be reverting back to “normal.” The Chinese markets had been a three-month lead indicator for US stocks around the 2007-09 financial crisis, a relationship that we utilized in the past, but it seems to have gone back to its historical norms of much of the 2000s when the two stock markets were being driven by their own unique drivers in the form of monetary policy, earnings and economic growth. The global growth intersect during the banking sector woes in the US was very significant given the large impact of US demand for most exporting nations, but the reverse is not as crucial with near 70% of S&P 500 revenues being generated domestically while Chinese demand represents less than 2%.

Here's a chart that shows the brief 2007-09 link. "[T]hat relationship was more the anomaly than the norm if one looks back over the past 12 years."

Thus short SPX long SHCOMP could be an interesting speculation. Probably a better trade today than the short SPX/long IBEX trade that has worked well since I recommended it at Ira Sohn (up 8.3% on the pair trade).